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Coming patent expirations on key drugs and the development and marketing of products now in the pharmaceutical industry's pipeline could alter company revenue and profits significantly in coming years. As a result, drug-stock investors are focused not only on this year's earnings but also on those in the distant future.

Mindful of the long-term view, Tim Anderson, an industry analyst at Sanford Bernstein, recently projected 2015 and 2020 profits for nine major U.S. and European drug companies in a report titled "The Long View: Is There Light at the End of the Pharmaceutical 'Patent Cliff' Tunnel?" Few analysts in any industry make such long-term projections.

The firms likely to have the biggest earnings gains also could be stock-market winners, while those with disappointing profits might be losers. Anderson is most bullish on Novartis, Merck and Pfizer and favorable toward Glaxo, although he rates it Market Perform.

There isn't much variation in the price/earnings ratios of major drug stocks, based on estimated 2011 profits. That means investors can buy companies with sharply rising earnings at only a modest premium to those whose earnings are likely to decline. The six would-be winners in the table below generally have lower price/earnings ratios than the losers, based on projected 2015 profits. All the winners have lower P/Es, based on Anderson's 2020 estimates.

"AstraZeneca and Lilly are in a tough place in the next few years" owing to large revenue losses from expiring patents of important drugs, Anderson says. "Novartis and Glaxo are two of the best-looking companies, and they are among the most diversified."

Novartis, whose U.S.-listed shares trade around 61, may post a 2020 profit of $7.67 a share, up from $5.50 in 2011, while Glaxo, whose stock fetches about 43, could generate earnings of $6 a share in 2020, up from the $3.70 estimated for this year.

A key industry problem—and the reason for depressed P/Es throughout the sector—is that the revenue potential of new drugs isn't expected to match current sales of Lipitor and other blockbusters set to lose patent protection in coming years. After such protection is lost, revenue from a drug can quickly drop by 75% or more, as patients switch to cheaper generic products. Despite $60 billion in research and development spending last year among the the nine companies listed, the Food and Drug Administration has been approving only about 20 new drugs a year.

Barron's wrote favorably about the industry a year ago ("Wonder Drugs," June 28, 2010), and our then-top picks—Merck, Pfizer and Sanofi—are up an average of 23% since then, ahead of gains of 19% for the industry and 22% for the S&P 500. One attraction for investors is drug-company dividends; the stocks yield more than 4%, on average.

Glaxo has a large consumer-products franchise, including Tums, Polident, Aquafresh and Nicorette gum, that kicks in about 20% of revenue. It is also one of three leading vaccine makers, along with Merck and Sanofi. Vaccines offer an annuity-like business model because generic competition is virtually nil due to the difficulty of gaining regulatory approvals.

Pfizer is the industry's main restructuring play as the company weighs sales or spinoffs of its consumer-products and animal-health businesses. Some have speculated that it might even spin off a portfolio of drugs, including Lipitor, that face looming patent expiration. Exiting from this so-called established-products business would reduce revenue by 50%, to $35 billion to $40 billion, giving new products, such as a treatment for rheumatoid arthritis, a bigger financial impact.

The Bottom Line

Novartis and Glaxo are buffered by nondrug businesses. Roche is a biotech giant, Pfizer a promising restructuring play. Merck has fewer patent expirations than rivals, and Sanofi is strong in emerging markets.

A year ago, Pfizer was the industry's most out-of-favor stock, but it since has rallied 40%, to a recent 20.60, as investors have grown more confident that the company can weather a coming string of patent expirations without a profit collapse. Anderson sees upside to 24 if the restructuring plays out and the company has some pipeline success. Merck has been hurt by some pipeline setbacks, but could benefit from its 2009 merger with Schering-Plough and fewer patent expirations than its rivals.

Sanofi is controversial because its CEO, Chris Viehbacher, is dismissive of stock buybacks and spent $20 billion earlier this year to purchase biotech-drug maker Genzyme when Sanofi's shares were trading for seven times earnings. Sanofi has a strong franchise in vaccines and diabetes and cancer drugs, as well as one of the best positions in the emerging markets. After 2012, when Plavix comes off patent in the U.S., Sanofi has no major patent expirations. At 40 a share, it trades for eight times its estimated 2011 profit and seven times projected 2020 earnings.

ROCHE IS THE WORLD'S TOP biotech company following its 2009 purchase of Genentech. It is also a leader in diagnostics, including in-vitro procedures. Its P/E ratio has contracted sharply in recent years, despite a still-strong growth outlook. Its U.S.-listed shares fetch 42, or 11 times estimated 2011 profit and eight times estimated 2015 and 2020 profits.

Bristol-Myers arguably is the industry's R&D champ. It has shed businesses outside of prescription drugs and aims to create a "string of pearls" involving new drugs. The strategy looks smart, given the likely approval of a promising drug for malignant melanoma with more than $1 billion in annual sales potential, and other possible winners. Bristol's success, however, seems reflected in its stock, which trades for 29, or 13 times estimated 2011 profit. Anderson sees no earnings growth in the next decade, as patent expirations on products like Plavix (shared with Sanofi) offset the impact of new ones.

Eli Lilly and AstraZeneca face major patent expirations in the next five years. Lilly's earnings could drop to $3 a share in 2015 and $2 in 2020 from an estimated $4.28 this year. The company's lush dividend yield of 5% might not be sustainable, long-term.

Earnings growth is the best prescription for drug firms. On that score, Novartis, Glaxo, Roche, Pfizer, Sanofi and Merck should be the companies in investors' medicine cabinets.